Analysis - Canadian dollar set to drop further as economy struggles

NEW YORK/TORONTO The Canadian dollar, which has been declining against the U.S. dollar so far this year, is expected to slip further in the near term as a slowing Canadian economy and cooling housing market keep the nation's interest rates near historic low levels.

Speculators turned bearish on the loonie last week, with data from the Commodity Futures Trading Commission showing investors going net short for the first time since a brief retreat in mid-2012. <IMM/FX>

"There's been a very significant souring of the mood on the Canadian dollar over the past few weeks," said Shaun Osborne, chief currency strategist at TD Securities in Toronto.

The Canadian dollar, known in currency markets as the loonie because of the loon species of bird that appears on the nation's $1 (0.64 pounds) coins, has fallen 3.5 percent against the U.S. dollar in 2013, lately trading at C$1.0267, a move that contrasts starkly with the 20 percent gain achieved over the past 10 years.

The recent decline reflects Canada's dimming growth prospects. Data out Friday showed its economy grew by just 0.6 percent on an annualized basis in the fourth quarter, below the Bank of Canada's already reduced 1 percent forecast, and the economy actually shrank in December.

Growth has been hurt by a sharp slowdown in the country's once-hot housing market after the government last year imposed tougher mortgage rules to try to prevent a property bubble.

Deep discounts for Western Canadian oil, caused partly by a lack of pipeline capacity, have also hit growth. And the Canadian dollar's previous rise has hurt export-oriented manufacturers in Ontario and Quebec.

At the same time, the U.S. stock market's Dow Jones industrial average hit a new record on Tuesday and is up nearly 9 percent so far this year, which should be reflected in some increases in foreign capital flows into the U.S. dollar. By contrast, the Toronto Stock Exchange S&P/TSX composite index .GSPTSE has risen only 2.8 percent in 2013.

The slowdown means that Canada's central bank will likely keep monetary policy looser for a longer period than previously expected to try to boost growth.

Bank of Canada Governor Mark Carney, who leaves later this year to head the Bank of England, is expected to keep Canadian interest rates unchanged at a policy announcement on Wednesday. The disappointing data has many looking for the central bank to continue to tone down its previously hawkish language.

Forecasters don't expect a hike in the benchmark interest rate of 1 percent until at least the first quarter of 2014, according to a February Reuters poll. Previous polls pegged a rate hike for late 2013. <CA/POLL>

Interest-rate expectations play a prominent role in how investors bet in foreign exchange markets, with lower rates tending to reduce a currency's appeal.

The difference in yield between a two-year Canadian government bond and its U.S. equivalent was 95 basis points in mid-January. It has tightened to about 70 basis points since the Bank of Canada said in late January that a rate hike was "less imminent."

"The swing in positioning really has gone in lockstep with the decline in short-term interest rates in Canada," Osborne said.

Alessio de Longis, a portfolio manager at Oppenheimer Funds in New York who helps oversee $24 billion in assets, said it has held a "very large underweight" position in the Canadian dollar since the middle of January.

"Canada has a sharply deteriorating current account deficit and a very overvalued housing market," said de Longis. "In other countries, when the housing market cooled, their central banks had plenty of room to cut rates, but with BoC rates at 1 percent it has limited ammunition on that end."

Analysts said Canada's solid fiscal position and triple-A debt rating, a rarity among its Group of Seven peers, could act as a buffer against the currency's decline. But they warn dramatic changes in North American oil production, which has made the United States less reliant on Canadian supply, leaves the loonie vulnerable.

Oppenheimer's de Longis, who oversees the Currencies Opportunities Fund, said his team has been selling the currency outright in the spot market and bought bearish puts in the options markets.

"We expect the loonie to hit C$1.05-1.06 by mid-year and view C$1.10-1.20 as reasonable valuations," he said.

The options market shows demand firmly in favour of U.S. dollar calls, the right to buy dollars at a future date, with three-month risk reversals trading as high as 1.3 percent last week, the highest since September of 2012.

Risk reversals are a broad gauge of currency market sentiment that measure demand for protection against a currency's rise or fall. In this case, it measures the demand for call options in the U.S. dollar vs. the Canadian dollar; a rising value suggests increasing demand for the greenback.

Momentum indicators are suggestive of further gains for the U.S. dollar, said Camilla Sutton, chief currency strategist at Scotiabank in Toronto. She noted the 50-day moving average crossed above the 200-day moving average recently, a bullish indicator for the U.S. dollar.

Even if U.S. economic growth is hit short-term by government spending cuts that began March 1, it is unlikely to help the loonie. Soft U.S. growth is negative for the Canadian dollar due to the country's exposure to the U.S. economy, Bank of America-Merrill Lynch said in a research report published on Monday.

Still, analysts said the loonie's longer-term outlook is more positive. They note the Bank of Canada is still projected to raise interest rates well ahead of the U.S. Federal Reserve.

A separate poll on the outlook for the loonie conducted in early February suggested it would strengthen slightly through 2013. <CAD/POLL>

While Scotiabank forecasts C$1.04 in the near-term, it is predicting a drop to C$1.01 by the end of the year and for it to hit C$0.99 by the end of 2014.

"The Canadian housing market is a major concern to Canadian dollar investors; however we see housing drivers, like interest rates, immigration, employment and commodities, as supporting only a moderation in housing, not a collapse and that this in turn should prove positive for the Canadian backdrop," Scotiabank's Sutton wrote on Tuesday.

(Reporting By Julie Haviv in New York and Alastair Sharp in Toronto; Editing by Jeffrey Hodgson, David Gaffen and Tim Dobbyn)

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